Virtual Insanity: It's What We're Living In

Several tech companies promise future riches through virtual means, but look beyond the number of users.

Would you pay $80 for a company that earns $1 in profit per year? Maybe if it had great growth prospects, but how about if this company experienced its first ever decline in revenue in its most recent quarter?

What about paying $4 for a company that earns $1 in revenue per year, and records fewer daily active users now than before it went public?

Obviously, you would want more information on each company before making a decision, but these numbers help exemplify the outsized valuations and shareholder aspirations of select social media stocks. The first company, of course, is Facebook(Nasdaq: FB), and the second is Zynga(Nasdaq: ZNGA).

These companies will never meet their optimistic visions of monetizing users, and investors should be weary of similar businesses.

Social media's "value"Online services are often valued by the number of users, with the monetization of those users as an afterthought. This causes Facebook to give away its service for free, and Zynga to give away its games for free as the strategy to ramp up number of users and perceived value of the business. However, a company still needs to find a sustainable way to make money, not just attract users.

Sustainable business modelsZynga is able to earn more than 90% of its revenue from selling in-game virtual goods, with the remainder coming from advertising. Facebook reverses this proportion with about 80% of revenue coming from advertising, and the remainder coming from fees and payments charged for things like Zynga games played on Facebook.

Serving ads can be a legitimate business, but even with the mountains of user information available to a service like Facebook, it hasn't proven that its advertising prowess is any better than a standard newspaper's. Take these statistics:

On average, 1 in 1,000 online ads are clicked -- last year on Facebook, that average is 1 in 2,000; at Google(NYSE: GOOG), the average is 4 in 1,000.

The younger generation clicks on ads even less, with 18- to 34-year-olds clicking between 1 in 3,000 to 1 in 5,000 ads.

General Motors(NYSE: GM) stopped buying Facebook ads, and while they only paid Facebook $10 million per year, GM is the third largest advertiser in the U.S. and spent almost $2 billion in U.S. advertising.

And while Zynga depends much less on advertising, it fights to maintain a dwindling user base to which it sells its virtual goods. According to AppData, Zynga had 274 million monthly users at the beginning of May, and now has 247 million -- a decline of about 10%. Zynga must keep pumping out games to maintain freshness and users, but has also been willing to shell out significant cash for a trending title. In March, Zynga paid $180 million in cash to buy OMGPOP, which created the game Draw Something. Unfortunately, since that acquisition, Draw Something's active monthly users have dropped roughly 20%, and active daily users have dropped roughly 40%.

Fascinating services, failing investmentsThere's no question that Facebook has changed society's social life, but for its current business model, it deserves a price more in line with old media. Facebook will find other revenue streams, but nothing that gives it its current valuation.

Zynga, like a teenager, craves popularity and needs it to survive. Unfortunately, popularity does not make a good business model, and the investment required to continue creating and acquiring top games will be a drag on any future returns.

LinkedIn(NYSE: LNKD), on the other hand, offers its free users a chance to purchase premium options and offers businesses real value in recruiting employees. Would you rather pay for a virtual tractor, or pay to enhance your chances at finding a better job? Additionally, LinkedIn's advertising segment accounts for a shrinking proportion of its revenue, currently at 26%. There's less and less of a need for LinkedIn to depend on the advertising business cycle.

For more select companies that don't depend on questionable business models, check out our free report that can help you build a smarter retirement portfolio: "3 Stocks That Will Help You Retire Rich."